The Lucas critique, named for American economist Robert Lucas's work on

macroeconomic Macroeconomics (from the Greek prefix ''makro-'' meaning "large" + ''economics'') is a branch of economics dealing with performance, structure, behavior, and decision-making of an economy An economy is an area of the production, distributio ...

policymaking, argues that it is naive to try to predict the effects of a change in

economic policy The economy of governments covers the systems for setting levels of taxation, government budgets, the money supply and interest rates as well as the labour market, national ownership, and many other areas of government interventions into the e ...

entirely on the basis of relationships observed in historical data, especially highly aggregated historical data. More formally, it states that the decision rules of Keynesian models—such as the consumption function—cannot be considered as structural in the sense of being invariant with respect to changes in government policy variables. The Lucas critique is significant in the

history of economic thought History (derived ) is the systematic study and the documentation of the human activity. The time period of event before the invention of writing systems is considered prehistory. "History" is an umbrella term comprising past events as well ...

as a representative of the

paradigm shift A paradigm shift, a concept brought into the common lexicon by the American physicist and philosopher Thomas Kuhn, is a fundamental change in the basic concepts and experimental practices of a scientific discipline. Even though Kuhn restricted ...

that occurred in macroeconomic theory in the 1970s towards attempts at establishing micro-foundations.

Thesis

The basic idea pre-dates Lucas's contribution—related ideas are expressed as

Campbell's law Campbell's law is an adage developed by Donald T. Campbell, a psychologist and social scientist who often wrote about research methodology, which states: Applications Campbell's law is related to the cobra effect, which is the sometimes unint ...

and

Goodhart's law Goodhart's law is an adage often stated as, "When a measure becomes a target, it ceases to be a good measure". It is named after British economist Charles Goodhart, who is credited with expressing the core idea of the adage in a 1975 article on mon ...

—but in a 1976 paper, Lucas drove to the point that this simple notion invalidated policy advice based on conclusions drawn from

large-scale macroeconometric model Following the development of Keynesian economics, applied economics began developing forecasting models based on economic data including national income and product accounting data. In contrast with typical textbook models, these large-scale macro ...

s. Because the parameters of those models were not structural, i.e. not policy-invariant, they would necessarily change whenever policy (the rules of the game) was changed. Policy conclusions based on those models would therefore potentially be misleading. This argument called into question the prevailing large-scale econometric models that lacked foundations in dynamic economic theory. Lucas summarized his critique:

Given that the structure of an econometric model consists of optimal decision rules of economic agents, and that optimal decision rules vary systematically with changes in the structure of series relevant to the decision maker, it follows that any change in policy will systematically alter the structure of econometric models.

The Lucas critique is, in essence, a negative result. It tells economists, primarily, how ''not'' to do economic analysis. The Lucas critique suggests that if we want to predict the effect of a policy experiment, we should model the "deep parameters" (relating to

preferences In psychology, economics and philosophy, preference is a technical term usually used in relation to choosing between wikt:alternative, alternatives. For example, someone prefers A over B if they would rather choose A than B. Preferences are centra ...

technology Technology is the application of knowledge to reach practical goals in a specifiable and reproducible way. The word ''technology'' may also mean the product of such an endeavor. The use of technology is widely prevalent in medicine, scie ...

, and

resource constraints Resource slack, in the business and management literature, is the level of availability of a resource. Resource slack can be considered as the opposite of resource scarcity or resource constraints. The availability of resources can therefore b ...

) that are assumed to govern ''individual'' behavior: so-called " microfoundations." If these models can account for observed empirical regularities, we can then predict what individuals will do, ''taking into account'' the change in policy, and then aggregate the individual decisions to calculate the macroeconomic effects of the policy change. Shortly after the publication of Lucas's article,

Kydland Finn Erling Kydland (born 1 December 1943) is a Norwegian economist known for his contributions to business cycle theory. He is the Henley Professor of Economics at the University of California, Santa Barbara. He also holds the Richard P. Simmon ...

and Prescott published the article "Rules rather than Discretion: The Inconsistency of Optimal Plans", where they not only described general structures where short-term benefits are negated in the future through changes in expectations, but also how time consistency might overcome such instances. That article and subsequent research led to a positive research program for how to do dynamic, quantitative economics. The Lucas critique was an important methodological innovation. It does not invalidate that fiscal policy may be countercyclical, which some associate with

John Maynard Keynes John Maynard Keynes, 1st Baron Keynes, ( ; 5 June 1883 – 21 April 1946), was an English economist whose ideas fundamentally changed the theory and practice of macroeconomics and the economic policies of governments. Originally trained in ...

Examples

One important application of the critique (independent of proposed microfoundations) is its implication that the historical negative correlation between

inflation In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reductio ...

and

unemployment Unemployment, according to the OECD (Organisation for Economic Co-operation and Development), is people above a specified age (usually 15) not being in paid employment or self-employment but currently available for work during the refer ...

, known as the

Phillips curve The Phillips curve is an economic model, named after William Phillips (economist), William Phillips hypothesizing a correlation between reduction in unemployment and increased rates of wage rises within an economy. While Phillips himself did no ...

, could break down if the monetary authorities attempted to exploit it. Permanently raising inflation in hopes that this would permanently lower unemployment would eventually cause firms' inflation forecasts to rise, altering their employment decisions. In other words, just because high inflation was associated with low unemployment under early 20th century

monetary policy Monetary policy is the policy adopted by the monetary authority of a nation to control either the interest rate payable for very short-term borrowing (borrowing by banks from each other to meet their short-term needs) or the money supply, often ...

does not mean that high inflation should be expected to lead to low unemployment under every alternative monetary policy regime. For a simple example, consider the question of how much

Fort Knox Fort Knox is a United States Army installation in Kentucky, south of Louisville and north of Elizabethtown. It is adjacent to the United States Bullion Depository, which is used to house a large portion of the United States' official gold r ...

should spend on protection. Fort Knox has never been robbed. Statistical analysis using high-level, aggregated data would therefore indicate that the probability of a robbery is independent of the resources spent on guards. The policy implication from such analysis would be to eliminate the guards and save those resources. This analysis would, however, be subject to the Lucas Critique, and the conclusion would be misleading. In order to properly analyze the trade-off between the probability of a robbery and resources spent on guards, the "deep parameters" (preferences, technology and resource constraints) that govern individual behaviour must be taken explicitly into account. In particular, criminals' incentives to attempt to rob Fort Knox depends on the presence of the guards. In other words, with the heavy security that exists at the fort today, criminals are unlikely to attempt a robbery because they know they are unlikely to succeed. However, a change in security policy, such as eliminating the guards, would lead criminals to reappraise the costs and benefits of robbing the fort. So just because there are no robberies under the current policy does not mean this should be expected to continue under all possible policies. In order to answer the question of how much resources Fort Knox should spend on protection, the analyst must model the "deep parameters" and strive to predict what individuals will do conditional on the change in policy.

Thesis

Examples

See also

References

Further reading